The Architecture of Financial Regulation: July 2010 Archives

The
Federal Reserve System was born of a financial crisis, the Panic of 1907, so it
is not surprising that the global crisis which began one century later should
lead to changes in the authority and responsibilities of the Fed. The Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 mandates the most
important changes at the Fed since the Great Depression. The legislation
explicitly expands the goals for the Fed to include financial stability in
addition to the traditional goals of price stability and full employment.

Consequently,
the central bank will have enhanced responsibility for systemic risk assessment
and regulation, and it will house and fund a new Consumer Financial Protection
Bureau. Yet, in addition to expanding the powers of the Fed, the Dodd-Frank
bill also significantly narrows the Fed's emergency lending authority and
subjects this lending to greater scrutiny.

The
actions of the Federal Reserve in the recent financial crisis highlighted the
extraordinary powers that many central banks have to intervene in an economy in
a crisis. Not surprisingly, the interventions led to a vigorous public debate
about the choices the Fed made, the proper role of the Fed in a crisis, and the
transparency of its actions.Although
Dodd-Frank expands the Fed's responsibilities regarding financial stability, it
also seeks to rein in an independent and powerful financial institution with
unelected leadership and limited accountability.

The
role of a central bank in financial crises is a topic with a long history. With
the help of Walter Bagehot, the Bank of England learned in the 1860s and 1870s
that proper behavior on the part of a lender of last resort is to furnish
liquidity to the market by discounting freely when presented with good
collateral, at a penalty rate of interest that incentivizes borrowers to repay.
In the recent crisis, the Fed developed a range of facilities to deliver
liquidity. The Fed intervened to an unprecedented degree, reacting quickly to
create vast reserves and shoring up institutions in novel ways to prevent a
wholesale collapse of the U.S. financial system.

But
the Fed and some other central banks also went well beyond what Bagehot taught
a century and a half ago. In addition to lending to the market, they lent to
particular institutions in trouble, sometimes on dodgy collateral, thereby
attracting great political criticism.Even in lending to the market, the Fed expanded its traditional role as
lender of last resort to become an investor of last resort as well. One
could argue that this was an appropriate means to prevent a widespread systemic
collapse of the financial system. Yet, it was bound to add to concerns about
the range of Fed powers.

Not surprisingly, Congress has turned its attention to ways
to improve financial sector regulation and avert future crises. The changes to
the role of the Fed that are introduced by the Dodd-Frank bill arise mostly out
of serious thought about the role of central banks and the appropriate scope of
their activity. But, there also are lingering reflections of the public anger
triggered by the crisis and the Fed's role in it.

There
are three aspects of central bank activities - monetary policy, financial
institution regulation and systemic risk oversight.In our view, the strong linkages among the
three functions are sufficiently compelling that, with proper oversight, the
central bank should have broad authority in all three of them. The Dodd-Frank
bill takes some steps in this direction. It gives the Fed a role in maintaining
financial stability and sets the stage for its use of macroprudential tools to
tame systemic risks. It does not diminish the Fed's responsibility for monetary
policy. Finally, it leaves the Fed explicit responsibility for some aspects of bank
regulation and, importantly, creates new supervisory authority over all
financial institutions that are deemed officially to be systemically important.

A
strong and independent central bank is indispensable for effective monetary
policy. However, it also is an anomalous entity in a constitutional democracy
that emphasizes accountability and the responsibility of elected
officials. Fortunately, the Dodd-Frank bill leaves the independence of the
Federal Reserve reasonably intact. Some specific challenges to central bank
independence that were introduced in earlier Congressional discussion were
misguided and potentially counterproductive expressions of public anger
regarding the recent financial crisis. Anger is a poor basis on which to make
effective reforms. The Dodd-Frank bill dropped the most egregious attacks on
the Fed.

With
regard to regulatory and systemic oversight, the Fed's enhanced powers to use
macroprudential tools and the policy focus provided by its new Vice Governor
for Supervision may help prepare both the central bank and the government for
systemic risks.

However,
the Dodd-Frank bill also prohibits or delays the use of selected Fed crisis
management tools that played an important role in mitigating the recent crisis.
In particular, aside from broad-based programs of liquidity provision, the Fed
may no longer lend to individual nonbanks whose solvency is in doubt. Instead,
the bill relies heavily on new, complex, and potentially unwieldy regulatory
and resolution mechanisms to prevent and tame future crises.

It
is far from clear that this new apparatus will prove effective in countering
crises when they occur, and may even increase their likelihood. The Financial
Stability Oversight Council is an umbrella group of policymakers with a staff housed
in the Treasury that will seek to identify systemic risks and instruct the Fed
to respond. This loose structure is untested and far from streamlined. It does
not appear well suited to foster the strong leadership, clear chain of command,
and timely interventions that have characterized successful policy responses
over the long history of financial crisies. In addition, the bill's new
resolution mechanism - which aims to protect taxpayers and impose the costs of
financial failures on unsecured creditors -- may unintentionally increase the
probability of a run by such creditors in response to a shock that weakens the
financial system.

Ultimately,
the combination of new restrictions on Fed emergency lending and the new
structures for responding to systemic risk and financial crises will have to be
judged when tested by events. If the new structures prove ineffective,
the Dodd-Frank bill's elimination of emergency authority for some forms of Fed
lending could make future crises even more devastating than the recent one.

About RegulatingWallStreet.com

The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).